Option Pricing | |
Understanding the factors that influence an option's price is essential to understanding options. The three factors which have the greatest impact on the option price are 1) the price of the underlying stock versus the strike price, 2) the time until expiration, and 3) the volatility. If the option grants the right to buy a stock at $50 and the stock is trading at $55, then that option would be worth at least $5, and more expensive than if the stock were trading at $51. The longer the option lasts the more expensive the option will be, since there is more time, and hence a greater probability, that the position will become profitable over the life of the option. If the underlying stock price changes frequently, there is theoretically a greater probability that it will continue to change. The increased probability of the stock price changing, called volatility, results in a rise in the option price. Prevailing interest rates. the underlying stock's dividend yield, the quality of the underlying stock, overall market conditions, and the current market for the individual option contract also influence an option's premium. Most option pricing models consider five basic factors when computing option prices:
A high level discussion of these five factors follows. For a more advanced discussion on pricing, skip to Chapter 3.
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